Fin management materials / P4AFM-Session10_j08

SESSION 10 – EQUITY & DEBT ISSUES

7DETAIL ON METHODS

7.1Offer for subscription

¾Offer for subscription - when a firm issues new shares to new shareholders directly.

¾The problem in making an offer for subscription for most companies is that they lack the expertise to sell their shares to the public directly. This means that it is typically only used by experts in this field, such as investment trusts.

¾Most trading companies will use a similar method, the offer for sale.

¾Stock Exchange rules concerning offers for sale and subscription are the same.

7.2Offer for sale

¾In an offer for sale the company issues shares to an issuing house (usually an investment bank) which then sells the shares to the public.

¾In addition to selling shares newly issued by the company, the issuing house can also sell shares to the public which were previously owned by the original shareholders - thus enabling them to realise their investment.

7.3Fixed price or tender offer

¾Fixed price - where the price per share is fixed by the company in advance of the offer and the public are invited to subscribe at that price.

¾Tender offer - where the public are invited to tender for shares, offering whatever price they think is appropriate subject to a minimum tender price set by the company. The company will set a strike price for the offer based on tenders received Investors who tendered at higher prices will receive preference.

Illustration of a tender

XYZ plc wishes to issue 1,000 shares by way of tender and sets a minimum tender price of $2.00 per share. The following tenders are received.

XYZ plc could theoretically set the strike price at $3.00 per share, issue 500 shares to A and 250 shares to B and C at this price, with no shares being issued to D.

In practice, the price may be set at below $3.00 in order to stimulate trading in the secondary market.

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¾The two approaches may be compared as follows:

¾Overall, if the wish of the company and its existing investors is to achieve wide share ownership and to appeal to the public in general, the fixed price offer is likely to be the better alternative.

¾If the company wishes to target its investor base more carefully and to ensure that it issues shares so as to obtain best value for existing shareholders, the tender approach is likely to be superior.

7.4Book building

¾The book building approach is to some extent a merging of the two above methods, the fixed price and the tender.

¾The idea of book building is that the issuing house gauges demand for the issue prior to setting a fixed price for the offer. Investors are asked to indicate, either on a firm or uncommitted basis, as to the best price which they will offer and the maximum number of shares that they will buy at particular prices. This information will enable the issuing house to build up a demand curve and establish the most appropriate offer price for the issue.

¾The advantage of using book building is that it can build up market tension and increase demand for the shares and the final issue price.

¾It is highly suitable for large issues where underwriting would not be possible due to the size of the risk to which the underwriters would be exposed. It is a well established as a technique in the UK and US markets

¾The technique does have potential problems however. While creating tension may drive the issue price up for a popular share, there is the possibility that investors will all wait to see what others do, particularly with in uncertain markets. If no one is prepared to take a lead then the issue may never get started.

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¾In addition, it is possible for investors to sell the stock short prior to the issue in an attempt to drive the price down upon issue i.e. first sell the shares, wait for the price to fall upon their issue, buy them at the lower price and take a quick gain.

¾In order to combat these problems the issuing house will need to:

Establish an anchoring market place to get the issue off the ground.

Establish a sophisticated computer system to enable global demand to be accurately tracked on an instantaneous basis.

Establish detection techniques to identify sellers of the stock prior to the issue. This will require good relations with market participants so that all sellers can be identified.

Have the power to punish institutions who sell short in the above fashion.

Have the ability to stabilise the market after issue.

8ALTERNATIVES TO THE MAIN MARKET

8.1Listing on the Alternative Investment Market (AIM)

AIM is a subsidiary of the London Stock Exchange.

Specifically tailored to growing businesses, AIM combines the benefits of a public quotation with a flexible regulatory approach.

AIM gives companies from all countries and sectors access to the market at an earlier stage of their development, allowing them to experience life as a public company. Since AIM opened in 1995, more than 1,300 companies have been admitted and more than £11 billion has been raised collectively.

Differences in the admission criteria for the Main Market and AIM:

SESSION 10 – EQUITY & DEBT ISSUES

8.2Trade sale to another company

¾The trade sale is an alternative means of realising the investment and is, in fact, the more common occurrence in practice for a successful company.

¾The decision whether to use floatation or trade sale as the exit route depends on a number of factors.

8.2Unquoted equity finance

¾An alternative to listing on either the Main Market or AIM is to use a private equity provider of expansion finance e.g. venture capitalists or business angels.

¾Possible advantages:

9 an equity investor can be selected whose vision for the business matches that of the existing shareholders/directors.

9the investor may have existing business interests in connected fields, creating possibilities of shared R&D, transfer of management skills i.e. “synergy”.

9a private investor may be prepared to take a more long-term view than institutional investors on the stock market; reducing the risk of myopia.

¾Possible disadvantages:

8 dilutes the interests of existing shareholders.

8 new investors may demand a seat on the board.

8 the level of funds which can be raised in this way is probably less than available

from a public listing.

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8.3Debt finance

¾The advantages of debt finance compared to equity:

9 lower issue costs;

9 providers of debt take less risk than shareholders and hence require lower returns;

9 interest is tax allowable – the “tax shield”;

9 leaves control of the company with existing shareholders;

9 ensures that all the benefits of success stay with the existing shareholders;

¾The disadvantages of debt are:

8 only available in limited quantities up to acceptable gearing levels;

8leads to financial risk for shareholders i.e. more volatile profits due to the presence of committed interest costs.

8exposes the company to the risk of insolvency should operating profits and cash flows fall – financial distress risk.

8restrictive debt covenants may limit the firm’s flexibility-leading to “agency costs” for shareholders i.e. sub-optimization of returns.

9DOMESTIC DEBT MARKETS

9.1Main products available

¾Debentures - simple corporate bonds backed by either fixed or floating security.

¾Unsecured loan stock.

¾Convertible bonds.

¾Medium Term Notes (MTN’s) -The MTN market is used to issue bonds with irregular interest or capital payments. The MTN market is regulated by The Bank of England.

9.2The issuance process

¾The Listing Agent acts as the sponsor and co-ordinates the other advisers (these are the same as for an equity issue).

¾The issuing process is monitored by the British Merchant Bankers Association who conduct the initial screening and ensure that the Stock Exchange’s entry procedures are carried out (the procedures are the same as for an equity issue). The BMBA also operate a queuing system, which ensures that several large issues do not hit the market at one time.

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10 THE EUROMARKETS

Definition

The banking and financial markets which are located outside the country which issued the currency.

10.1Components

International bank borrowing/lending:

¾Eurocurrency market

¾Eurocredit market

International securitized (traded) debt instruments:

¾Euronote market

¾Eurobond market

Note that use of the word “Euro” does not refer to the European single currency. It relates to funds which are outside their home country i.e. offshore, and hence beyond the regulation of the central bank that issued them.

10.2The Eurocurrency market

Definition

Eurocurrency is currency deposited outside of its country of issue.

Characteristics:

¾Short to medium-term deposits (overnight up to 5 years)

¾Investors and borrowers are blue-chip companies and governments – an international bank is the intermediary

¾As the currency is offshore the bank is outside of government regulation and has more flexibility than domestic banks e.g. is able to lend 100% of its deposits and therefore applies a relatively narrow spread between investing and borrowing rates

¾Borrowing possible up to several years (most is under one year)

¾Floating rates quoted as LIBOR +

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Advantages (to both investors and borrowers)

9Higher interest rates for investors than in domestic markets

9Lower interest rates to borrowers than in domestic markets

9Interest is paid gross to investors i.e. no withholding tax

9Very large loans can be arranged more quickly than in domestic markets

10.3The Eurocredit market

Definition

Medium to long-term international bank loans given by banks located outside the country which issued the currency.

Characteristics:

¾Major borrowers are multinationals, governments and other banks

¾Average maturity is 8 years

¾Floating rates

¾Large sums are syndicated i.e. made by a group of banks

10.4The Euronote market

Definition

A variety of short to medium-term debt instruments issued in the

Euromarkets.

Instruments available:

¾Eurocommercial Paper - securitized borrowing where a company writes a short-term promissory note (less than 12 months). Only companies with very high credit ratings can issue commercial paper. Banks create a secondary market by buying the paper before its maturity date.

¾Euro Medium Term Notes – maturities from 9 months up to 10 years; filling the gap between commercial paper and long-term bonds

¾Note Issuance Facilities – medium term commercial paper written by companies but underwritten by banks

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¾Revolving Underwriting Facilities – a series of short term paper issues designed to raise medium term finance at short term rates

10.5The Eurobond Market

Definition

Eurobonds are long term debt securities denominated in a currency outside of the control of its country of origin.

Characteristics:

¾underwritten by an international syndicate of banks

¾The main issuers are large multinationals, governments and banks

¾Usually unsecured but high credit rating is required

¾Fixed or Floating Rate Notes

¾Many Eurobond issues are combined with swaps (either interest rate swaps or currency swaps)

Advantages of Eurobonds:

9Relatively low issue costs (2-2.5%)

9Interest can be paid gross to investors

9“Bearer form” – there is no register of investors; possession of the certificate is proof of ownership. This provides privacy to investors,

9Very large sums can be raised relatively quickly at attractive interest rates

9Existence of secondary market

History of the market

¾in the 1950s the US, unlike most countries, had no currency controls. As a result large amounts of dollars were held outside the US.

¾As a result of the lack of currency controls the US dollar became the currency of international trade leading to a demand for US dollars outside of the US. This led to the birth of the Eurobond market in London.

¾Regulation was introduced in the 1980s by the formation of the International Primary Markets Association.

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Eurobond primary market

¾The Primary market refers to new issues of Eurobonds.

¾Bonds are marketed by a lead manager who sells the bonds to a syndicate of banks. The banks then sell on to their clients.

¾Historically the clients then held the bonds to maturity, though this pattern has changed to some degree over recent years.

Eurobond secondary market

¾The secondary market is the process by which Eurobonds are traded once they have been issued.

¾The market is small with very few issues being traded.

¾When trading takes place it is done on an “Over The Counter” basis based on information provided by such companies as Reuters. Deals are agreed directly between investors rather than via a formal market.

Key points

The rules for listing shares on a major market such as London are inevitably detailed and strict in order to give potential investors sufficient protection and maintain confidence in the market.

For exam purposes it is not necessary to know all details but knowledge of the main steps in a listing, the parties involved and the types of share issue is essential.

Bonds can also be listed on the London Stock Exchange. However companies with good credit ratings may prefer to use the Euromarkets in order to achieve lower interest rates and access large sums relatively quickly.

FOCUS

You should now be able to:

¾explain the process of issuing shares on a major market such as the London Stock Exchange;

¾explain the process of issuing domestic debt;

¾explain the nature and uses of the Euromarkets.

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